These days, examiners are much less inclined to put lenders in a ‘penalty box’ to prevent them from growing

Brooke Masters

Since US regulators loosened the Volcker rule that bans banks from engaging in proprietary trading, reactions have been starkly different.Banking lobbyists downplay last week’s changes to regulations designed to prevent banks from using insured deposits to make risky short-term bets. They say the changes reduce fiendishly complex compliance rules that make it hard for bankers to do their main jobs of making markets and providing services to clients. As a result, they say, the rule change should boost liquidity in the debt markets, which would make them more resilient in case of a downturn.The industry argues that higher capital requirements for trading in general — more than three times pre-2008 levels — will prevent a repeat of the financial crisis. “The largest US banks are not prop trading now, and they will not be prop trading tomorrow,” says Kevin Fromer, who heads the Financial Services Forum, which represents the biggest US banks.Consumer groups and some regulators see the Volcker rule change quite differently. The new version cuts the pool of financial instruments covered by the rule by at least one-quarter, according to a regulator who voted against the change. It not only frees banks up to take more short-term bets but also reduces the documentation requirements, opening the door to more risky trading. Critics also point out that if banks find ways to trade on their own account, rather than for clients, it could reawaken the poisonous conflicts of interest that flourished ahead of the 2008 crisis.“Banks didn’t spend nine and a half years and tens of millions lobbying to get these rules changed if they didn’t want to do prop trading and it wasn’t going to return them many multiples on what they spent,” says Dennis Kelleher of the advocacy group Better Markets. The Volcker rule rewrite is part of a much larger shift under US president Donald Trump, who came into office promising to kill two regulations for every new rule he put in place. Supporters and opponents agree that he has far exceeded that ratio. Acting budget director Russell Vought boasted this summer that “we’ve hit 13 to one”, adding that the eliminated rules had saved taxpayers $33bn.Liberal groups keep running lists of the rules and regulations Mr Trump’s administration has watered down or scrapped. This month alone, according to the Brookings Institution, there are seven entries and the Volcker rule hasn’t been included yet. They include weakening the Endangered Species Act, reducing penalties on automakers who fail to meet fuel efficiency standards and rejecting a ban on chlorpyrifos, a pesticide linked to developmental and autoimmune disorders.In the financial sector, this change in attitude has led the US Federal Reserve to scrap one prong of its annual stress tests and ease the requirements for midsized banks to write “living wills” that lay out how they could be wound down in a crisis. A new rule requiring brokers to act in the “best interest” of their clients is seen as much less strict than a scrapped Barack Obama administration proposal that would have imposed a “fiduciary duty” on advisers.Industry insiders also say that the tenor of their interaction with government supervisors has changed. These days, examiners are much less inclined to put banks in a “penalty box” that prevents them from growing over anti-money laundering issues and other “matters requiring attention” (supervisor speak for “you need to fix this”). In some senses, this is par for the course. The US historically pingpongs between fits of regulation and spasms of deregulation, often depending on who is in power. The American system is also blessed — or cursed, depending on your perspective — with activist state officials who club together to try to counter overarching trends. Republican attorneys-general tried to block Obamacare; now Democratic attorneys-general are challenging Mr Trump’s environmental policies, launching antitrust probes of big technology companies and trying to stop mergers that federal regulators have approved.The combination of US loosening and state tightening echoes the mid-2000s, when George W Bush’s administration was dismantling environmental rules and declining to rein in hedge and mutual funds, while state officials led by Eliot Spitzer were using their enforcement powers to try to counteract him. (Yes, the biggest bank deregulation law passed under Bill Clinton, but Mr Bush continued the trend.) That era, as you may recall, ended with the collapse of Lehman Brothers in 2008. Back in 2019, the US is still subject to much stricter global capital and liquidity requirements, put in place after the crisis, as well as much of the Dodd-Frank financial reform act. And there is no evidence that America is suffering for it. The industry reported record 2018 profits and the US economy is still outpacing most of the developed world.But fears of a recession are rising and there are concerns about the swollen leveraged loan market. It seems like a good time to reinforce our financial defences rather than weakening them. Remind me, why exactly are we deregulating the banks right now?

The quotas on western investment into Chinese financial markets are no longer the main limiting factor on inflows

By Mike Bird

If we open it, they will come. Or so the logic of the Chinese government goes, when it comes to Western investment in its financial markets. That dream is unlikely to become reality.On Monday, the State Administration of Foreign Exchange, or SAFE, abandoned the ceiling on its two Qualified Foreign Institutional Investor programs, scrapping the total quota limit of $300 billion.It’s easy to see why the news sounds like some major liberalization: the system of limiting foreign investment has been in place since 2002, when it was implemented with a $10 billion ceiling. That limit was gradually increased, reaching $300 billion earlier this year.But actual investment quotas allocated through the system have long been well below the ceiling. At the end of 2018, shortly before the cap was last raised, SAFE handed out $101 billion in QFII quotas, two thirds of the $150 billion limit. At the end of August, investment quotas allocated to QFIIs totaled around $110 billion.

Since 2014, the Stock Connect system linking Hong Kong and mainland markets has become a popular way for foreign investors to buy Chinese assets, sapping some activity under QFII. But even then, offshore demand doesn’t exactly look rapacious: net inflows into the Shenzhen and Shanghai stock exchanges via the tool have amounted to around 156 billion yuan ($21.93 billion) so far in 2019. At the same point in 2018, the total ran to 222 billion yuan.Chinese financial authorities might want to consider why investors overseas haven’t maxed out the previous limits. Skepticism about a volatile stock market that has risen by almost 20% in the last decade, and where sentiment-driven trading rules the roost, may be a bigger factor than Beijing’s arbitrary limits on inflows.When it comes to outbound investment, Beijing’s view is less “Field of Dreams,” and more “Hotel California.” Western capital can check in any time it likes; Chinese capital will be lucky if it gets to leave. No equivalent announcement was made about the Qualified Domestic Institutional Investor program, which allows Chinese institutions to buy foreign assets. Rather than numerical quotas, funds cannot invest more than a certain percentage of their assets abroad.Investments under QDII have risen, but slowly. At the end of August 2015, $89.9 billion was approved through the system. Four years later, it was $103.3 billion. The majority of such permissions to invest elsewhere are allocated to Hong Kong, meaning more exposure to China for the investors. Nearly two thirds of the sales of constituent companies of the Hang Seng Index are made in mainland China.Liberalization means more than just dropping the floodgates: the quality of the investments on offer matter too. Without more fundamental changes to make Chinese assets more attractive—like improved corporate transparency and less administrative interference when markets behave in ways Beijing doesn’t like—it’s hard to see this latest move generating much more than attention.

Every generation believes it’s different than those that came before. Then, reality sets in.

By George Friedman

Recent polls have shown that millennials are less patriotic, less religious and less interested in having children than previous generations. Many seem fascinated with the concept of millennials, believing that they are extraordinarily unique and the forerunners of fundamental shifts in the way we think and live. Given the attention that has been paid to this age group, it’s important to examine it with some care.

The term “millennial” applies to those born between 1980 and 1996. The oldest millennials are now approaching 40, while the youngest are 23. It is difficult to think of those in their early 20s and those about to turn 40 as being part of the same generation. Not only has the former group lived almost twice as long as the latter, but more important, they are at different points in their lives, one just entering the job market filled with a sense of self-worth and the other having worked for 15 or 20 years and discovered the limits of self-worth.

A generation is an arbitrary concept. Each stage of life is characterized by certain attitudes toward politics or culture. Millennials, for example, are generally thought to be progressive, yet the very definition of how a millennial lives and thinks is in its own way peculiarly biased by class, race and nationality, among other things. A 30-year-old American working for Goldman Sachs in New York experiences life differently than a 30-year-old housemaid in Georgia. And both experience life differently than a 30-year-old living in Tibet or Namibia.

Generations are meant to be global classifications, but the experience of being 30 is very different depending on the place in which one lives and class to which one belongs. Even if we confine the discussion to the United States, there are vast differences between people belonging to the same generation depending on geography, economic circumstances and so on.When people speak of millennials, I get the sense that they’re referring to college graduates, working flexible hours and playing video games while toying with the idea of socialism. Such people are certainly included in this group, but it must be remembered that 70 percent of high school graduates enter college and only about 60 percent of those who start college actually graduate. That means that less than half of all millennials finish college, which means that more than half of the generation is experiencing a very different life than the stereotype might represent.

I’m a member of the baby-boom generation that was regarded much the same as the millennials are now, as an extraordinarily unique group that would change everything and could not be understood by those who were older. We were perhaps best characterized by lyrics from a Bob Dylan song: “Come mothers and fathers throughout the land and don’t criticize what you can’t understand.”

This is true of all generations, some with more justification than others. Each generation encompassed a vast array of differences, and more important, each generation changed as they grew older. The baby boomers thought they had developed a new theory of sexuality accompanied by mind-liberating drugs.

That, at least, was how they were seen, although the vast majority did not get invited to the party.

Our adolescence and young adulthood was filled with arrogance and certainty. We then married and reinvented our parents’ lives – which we swore we wouldn’t do. We disappeared into the joys and tedium of having children, and when we came out of that, as with our parents, we discovered that we were no longer young or cool and that we were caught in professions that carried with them their own agony. I remember living in New York City in the 1960s and thinking that what we were doing there had never happened before, only to discover that our lives were a repeat of the endless drama of being human. By now, the oldest millennials have learned that lesson, as have those who never got to participate in the myth of the millennial.

This was all understood before the modern Enlightenment. Plato and the Bible are filled with the eternal process of life. But the Enlightenment introduced the concept of progress, the idea that humanity is on a path to perfection and that every generation stands on the shoulders of the preceding one, seeing more and farther than before. At the heart of this knowledge was science and technology.

These were the critical benchmarks of the evolution of humanity.

We live in a culture created by the Enlightenment. The ancients used to regard age and wisdom as linked. The Enlightenment turned time into something more.

Those who came later may not have been wiser, but by definition, they were more knowledgeable about nature, science and technology than their parents.

Rather than seeking the wisdom of age, they cherished the knowledge they had and conceded the irrelevance of those who were older. The proof for this was the development of technology that previous generations didn’t have.

Millennials are the latest in a line of generations from the past century, all of which were assumed to be bringing new ways of living and thinking, things that Dylan said their parents couldn’t understand. The things they bring are certainly new but not always better. I still insist that the Blackberry was far better than the iPhone. But then, it is the role of a baby boomer, which had to be the coolest generation of all time, to cede the field to the new cool generation, which all too soon will be replaced by the next generation.

There really is no such thing as a millennial. Differences in ages, cultures and classes make it impossible to fit so many people into one group. The baby boomers too were a myth. Many forget that those who fought in Vietnam were also boomers, yet they didn’t fit into the widely accepted definition of a boomer.

The danger in the concepts of boomers and millennials is that they create an illusion about what the future will hold. They imagine that the dreams of 20- and 30-year-olds will come to fruition. And these concepts exclude so many members of those generations who never have the opportunity to dream the dreams of the mythical generation.

What we want our lives to be and what they will be are very different. All the polls that ask millennials what they want now will reveal the dreams we all had before the reality of life set in. But one thing is certain. In another generation, the children of the millennials will laugh at the primitive video games of their parents and the idea of social media, promising that this time, it will all be different.

Jared DillianSince I started this 10th Man bond series, you guys seem to be split broadly into two camps.On one side, there are people who remain anti-bonds. Or at least, anti-investing-more-in-bonds.On the other side, there are the “yes, but” folks, who get why it’s important but feel blocked from doing much about it, for different reasons.Anyway, as I said last week, we’ll be throwing you a lifeline soon. I’m working on something pretty important that is a) going to make bond investing a lot easier and b) be beneficial even if you’re anti-bonds (yes, really).For now though, let’s continue with an article based on a question I’m getting from lots of you: how would you build a bond portfolio?

Best Practice

The best way to build a bond portfolio is to start by thinking about the risks.A portfolio of bonds can go down, you know.Yes, I know that US Treasurys cannot technically default (or at least, they haven’t so far). But they can decline in price, and the decline can be substantial.For example, if long term interest rates go up a lot—say 2% or so—the price of a 30-year Treasury bond could drop by as much as 40%. That’s a scary number. Most people aren’t worried about that right now. They may be someday.So we are definitely concerned about the direction of interest rates, known as duration risk. For US Treasury bonds, that is pretty much the only risk.For other types of bonds, there are other risks. Corporate bonds can and do default. They haven’t in a while, but they will someday. More importantly, the price of these bonds will decline as the market perceives companies to be less credit worthy. In the investment community, this is known as spread widening. The spread between corporate interest rates and Treasury interest rates will widen.In the last credit meltdown in 2015, led by energy credits, high yield spreads widened to about 700 basis points over Treasurys.That’s a bunch of gobbledygook to many people. What does that mean to me as an investor in a bond mutual fund?Well, if you own a high-quality investment grade corporate bond fund, the most it can probably go down because of credit concerns is about 5-7%. If it is a fund that is concentrated in BBB credits, perhaps a bit more.If you own a high yield bond fund that focuses on BB credits, your downside is probably capped at around 20%. If it owns mostly speculative CCC credits, you could lose 30% or more. This is also true for convertible bond funds.With international bonds, it is very much dependent on the situation, but emerging market bonds tend to be very economically sensitive and the downside could be large if we have a global recession.Mortgage-backed securities are pretty boring most of the time, except in 2008, or if interest rates rise rapidly.One day, municipal bonds will be very, very exciting. Although people have been saying that for 15 years or more.Now that we know the risks, let’s build a portfolio.

First Things First

What is your income? If it is north of $300K-$400K, you will want to consider owning lots of municipal bonds. Yes, I’ve heard all the arguments against munis—unfunded public pensions leading to muni bond defaults, blah blah blah. Maybe that is an issue in the next recession. Maybe not.For the rest of the portfolio, you will want a mix of Treasury and corporate bonds. With yields this low, people are tempted to massively overweight corporates. I understand that sentiment.By the way, one thing that is poorly understood about investment grade corporate bonds is that they are also very sensitive to interest rates. When Apple issued their first bonds back in 2013, people were surprised to see 10% of the value evaporate in a month—all on duration.High yield bonds have a little exposure to interest rates (especially with the low coupons these days), but not much. Mostly, they are correlated with stocks.So:Treasury—all interest rate risk.Investment grade corporates—some credit risk, some interest rate risk.High yield corporates—mostly credit risk (they behave like stocks).I don’t have a rubric here for what you should do, but your instincts on this—to overweight corporates to get more yield—are probably bad. This is actually the wrong time to be reaching for yield.It’s the right time to be reaching for safety. Had you done so 8 months ago, you would be pretty happy today. Treasury bonds are up over 20% this year.

Maturity Matching

The other thing you need to consider when building a bond portfolio is the length of maturity you want.Short-term bonds = less interest rate risk and less credit risk.Long-term bonds = more interest rate risk and more credit risk.You could just do it naively and pick a range of maturities. I’m not going to talk about it here, but you might want to do some research on bond laddering, the idea of which is to spread your risk along the interest rate curve.The school of thought is that you want to match your bond maturities with your liabilities.If you are going to retire in 30 years, you probably want 30 year bonds. If you are going to send a child to college in 10 years, you probably want 10 year bonds.If you have a view on interest rates, that can help. For example, I think that the Fed is likely to cut rates to zero and beyond. This would make shorter maturities more attractive.Once you put together your portfolio, you can figure out the weighted average maturity. A typical bond portfolio has a weighted average maturity of 5-7 years. If you are worried about interest rates or credit, you can make it shorter, or vice versa.

More Art Than Science

The key here is diversification. A portfolio full of municipal bonds will expose you to, well, the idiosyncratic risk that muni credit blows up.And yes, this is more art than science.And I know it’s not straight-forward. One reader said this recently: “I went into bonds hoping to ease up on time needed on my portfolio, but now I think shares are simpler!”He’s not wrong.But the bond market is much larger than the stock market. For many reasons, it is not clever to avoid it altogether.

In recent economic downturns, the United States has been more willing than normal to cooperate with China to try to spur a global recovery. So, although the Sino-American trade dispute continues to escalate, a US recession later this year or in 2020 may help to ease bilateral tensions.

Shang-Jin Wei

NEW YORK – The recent inversion of the yield curve in the United States – with the interest rate on ten-year US government bonds currently lower than that on short-term bonds – has raised fears of a possible US recession later this year or in 2020. Yet, paradoxically, a downturn in America could help to improve bilateral economic relations with China and cool the two countries’ escalating trade dispute.Recent history offers grounds for such predictions. True, by reducing import demand, US recessions normally have a negative impact on economies with a high trade-to-GDP ratio, including China. However, in recent downturns, the US also has been more willing than normal to cooperate with China in order to try to spur recovery.During the last major US recession in 2008-10, for example, China appeared to be the only major economy able and willing to boost global demand. Partly as a result of this, Sino-American ties improved, and the US even advocated giving China a greater voice in international bodies such as the International Monetary Fund and the G20.Similarly, US-China relations were at a low ebb in mid-2001, following a mid-air collision of a US reconnaissance plane and a Chinese fighter jet over the South China Sea, which resulted in the death of the Chinese pilot and the capture of the American crew. But after the September 11, 2001, terrorist attacks suddenly darkened the US economic outlook, US-China economic ties improved.Unlike its predecessors, US President Donald Trump’s administration may not have international cooperation in its DNA. But, tellingly, Trump initiated the current tariff war when the US economy was somewhat overheated, partly as a result of the aggressive tax cut that he pushed through Congress in late 2017. Frictions with America’s trading partners, which many economists believe are damaging both the US and the global economy, may in fact be helping to cool down the US economy. But Trump’s stance on China may soften, should a recession materialize. Two factors could derail this possibility. First, China may be unable or unwilling to provide economic stimulus. The Chinese government’s debt-to-GDP ratio is higher today than it was a decade ago, when the authorities rolled out an aggressive stimulus package to offset weakening export demand in the wake of the global financial crisis. That fact would seem to limit the government’s capacity to pursue an expansionary fiscal policy in the event of a US recession.

Even so, China’s debt-to-GDP ratio is still much lower than that of most other large economies, giving the government some room for additional fiscal stimulus in an economic emergency. Moreover, although the People’s Bank of China is more cautious about injecting liquidity at will, the relatively high reserve ratio the PBOC imposes on commercial banks suggests that it would have significant firepower should the need arise.The second risk factor is the 2017 US corporate tax cut, which enlarges America’s trade deficit with China, further damaging bilateral relations.America’s overall trade deficit reflects a shortage of US national savings relative to investment. By causing US government debt to increase by an additional $1-2 trillion over the next decade, the 2017 tax cut will make the government’s savings rate substantially more negative. Because it is unlikely to be offset by a decrease in national investment or a large enough increase in private-sector savings, the tax cut has contributed to a higher US trade deficit. The overall deficit this year is projected to be larger than in 2017 or 2018, and this trend is set tocontinue.This strongly suggests that the US trade deficit with China will increase. With US politicians and much of the media evidently failing to recognize the connection between Trump’s tax cut and the growing US trade deficit, they will most probably think the Chinese are doing something pernicious. For this reason, I have long argued that the US tax cut is a significant structural impediment to reducing America’s trade deficit with China (and with many other trading partners), and therefore a likely source of tension over the next few years.Nonetheless, the US trade deficit (as a share of GDP) typically decreases as the American economy weakens, because import demand tends to fall as well. A US recession may, therefore, somewhat moderate the negative impact of the Trump tax cut on the trade deficit.More important, the Chinese government has itself cut taxes aggressively since the end of 2018, reducing value-added tax (from 17% to 16% and then to 13%), lowering the corporate income-tax rate, and decreasing the social-security contribution rate for employers.Because these recent tax cuts are unlikely to be offset by lower investment or a sufficiently large increase in private savings, China’s national savings rate will most probably decrease. As a result, the country’s overall trade surplus – which reflects its excess of savings over investment – probably will be far smaller in 2020, and may even slide into deficit in one or two quarters. Although China will almost certainly still run a bilateral trade surplus with America next year because of the effect of the US tax cut, the imbalance will be much smaller than otherwise would have been the case.While a US recession would be bad news for the global economy in terms of a direct demand channel, it could help to normalize the troubled relations between America and China. If the world’s two largest economies get along better, businesses and investors everywhere will breathe a sigh of relief. This may turn out to be a silver lining in the next US recession.

Shang-Jin Wei, former Chief Economist of the Asian Development Bank, is Professor of Finance and Economics at Columbia University and a visiting professor at the Australian National University.

If you know the other and know yourself, you need not fear the result of a hundred battles.

Sun Tzu

We are travelers on a cosmic journey, stardust, swirling and dancing in the eddies and whirlpools of infinity. Life is eternal. We have stopped for a moment to encounter each other, to meet, to love, to share.This is a precious moment. It is a little parenthesis in eternity.